Inventory Management chapter 6

1
Inventory Management(chapter 67)
2
Outline Continued

• Functions of Inventory
• Types of Inventory

• Inventory Costs
• Holding, Ordering and Setup Costs

• Inventory Models for Independent Demand
• Economic Order Quantity (EOQ) Model
• Minimizing Costs
• Reorder Points
• Production Order Quantity (POQ) Model
• Quantity Discount Models

3
Outline Continued

• ABC Analysis
• Inventory Visibility
• How to evaluate the effectiveness of IM
• Pull vs. Push System
• Alternative Approaches JIT, MRP, DRP

4
Functions of Inventory

• To balance supply and demand
• To take advantage of quantity discounts
• To decouple or separate various parts of the
  production process
• To hedge against uncertainty/risk

5
The Importance of Inventory in Other Functional
Areas

• Marketing uses inventory to provide strong
  customer service.
• Manufacturing uses inventory to schedule longer
  production runs.
• Finance wants inventory turnover ratios to be
  kept high so that risk of inventory loss is
  reduced and rate of return on assets kept
  competitively high.

6
Types of Inventory

• Raw material
• Purchased but not processed
• Work-in-process
• Undergone some change but not completed
• A function of cycle time for a product
• Maintenance/repair/operating (MRO)
• Necessary to keep machinery and processes
  productive
• Finished goods
• Completed product awaiting shipment

7
Importance of Inventory Cost

• Inventory is the biggest asset on balance sheets
  of companies.
• Inventory costs are a significant portion of
  total logistics costs for many firms.
• Inventory levels affect customer service levels.
• Inventory cost trade-off decisions affect
  inventory carrying costs.

8
Independent Versus Dependent Demand

• Dependent demand is directly related to the
  demand for another product.
• Independent demand is unrelated to the demand for
  another product.
• For many manufacturing processes, demand is
  dependent. (JIT, MRP and MRPII )
• For many end-use items, demand is independent.
  (EOQ and DRP)

9
Inventory Costs

• Holding costs - the costs of holding or carrying
  inventory over time
• Capital, storage/handling, service, risk,
• Ordering costs - the costs of placing an order
  and receiving goods
• Setup costs the costs of preparing a
  manufacturing process for an order
• Stock-out costs (chapter 4)

10
Inventory Costs
11
Inventory Models (Fixed Order Quantity Approach
under Certainty)
Determine when and how much to order

• Economic Order Quantity (EOQ)
• Production Order Quantity (POQ)
• Quantity Discount Model

12
Basic EOQ Model
Important assumptions

• Demand is known, constant and independent
• Lead time is known and constant
• Receipt of inventory is instantaneous and
  complete
• Quantity discounts are not possible
• Only holding ordering costs considered
• Stockouts can be completely avoided

13
Inventory Usage Over Time
Order quantity Q (maximum inventory level)
14
Minimizing Costs
Objective is to minimize total costs
Annual cost
Minimum total cost, TC
Order quantity
Optimal order quantity, Q
15
The EOQ Model
Q Order quantity (Q Optimal order
quantity) D Annual demand in units S
Ordering cost per order H Holding cost per
unit per year
Annual ordering cost (Number of orders per
year) x (Ordering cost per order)
16
The EOQ Model
Q Order quantity (Q Optimal order
quantity) D Annual demand in units S
Ordering cost per order H Holding cost per
unit per year
Annual holding cost (Average inventory level)
x (Holding cost per unit per year)
17
The EOQ Model
Q Order quantity (Q Optimal order
quantity) D Annual demand in units S
Ordering cost per order H Holding cost per
unit per year
Optimal order quantity is found when annual
ordering cost equals annual holding cost
Solving for Q
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An EOQ Example
Determine optimal number of units to order D
1,000 units S 10 per order H .50 per unit
per year
19
An EOQ Example
Determine expected number of orders D 1,000
units Q 200 units S
10 per order H .50 per unit per year
Expected number of orders
N
20
An EOQ Example
Determine expected time between orders D 1,000
units Q 200 units S 10
per order N 5 orders per
year H .50 per unit per year of working
day/year250
Expected time between orders
T
21
An EOQ Example
Determine the total cost D 1,000 units
Q 200 units S 10 per
order N 5 orders per year H .50 per unit per
year T 50 days
Total annual cost Ordering cost Holding cost
(5)(10) (100)(.50) 50 50 100
22
EOQ Model is Robust

• It works even if all parameters and assumptions
  are not met
• The total cost curve is relatively flat in the
  area of the EOQ
• See the following example

23
An EOQ Example
Management underestimated demand by 50 D 1,000
units Q ? units S
10 per order N 5 orders per year H .50 per
unit per year T 50 days
(If we use the old Q)
24
An EOQ Example
Actual EOQ for new demand is 244.9 units D
1,000 units Q 244.9
units S 10 per order N 5 orders per year H
.50 per unit per year T 50 days
(If we use the new Q)
61.24 61.24 122.48
Only 2 less than the total cost of 125 when the
order quantity was 200
25
Reorder Points

• Q answers the how much to order
• The reorder point (ROP) tells when to order

d x L
Where usage rate demand per day
26
Reorder Point Curve
27
Reorder Point Example
Demand 8,000 DVDs per year 250 working day
year Lead time for orders is 3 working days
8,000/250 32 units
ROP d x L
32 units per day x 3 days 96 units
28
Production Order Quantity (POQ) Model

• Additional assumptions upon EOQ
• Products are produced and sold simultaneously
• Inventory builds up over a period of time after
  an order is placed, not instantly.

29
POQ Model
Inventory level
Time
30
POQ Model
Q Order quantity S Setup cost p Daily
production rate H Holding cost per unit per
year d Daily demand/usage rate t Length
of the production run in days (p gt d always)
31
POQ Model
Q Order quantity S Setup cost p Daily
production rate H Holding cost per unit per
year d Daily demand/usage rate t Length
of the production run in days (p gt d always)
Continued
Q total produced pt thus t Q/p
32
POQ Model
Q Order quantity S Setup cost p Daily
production rate H Holding cost per unit per
year d Daily demand/usage rate t Length
of the production run in days (p gt d always)
Optimal quantity is found when annual setup cost
equals annual holding cost
(D/Q)S 1/2 HQ1 - (d/p)
33
POQ Example
D 1,000 units p 8 units per day S 10 d
4 units per day H 0.50 per unit per year
34
Quantity Discount Models

• Reduced prices are often available when larger
  quantities are ordered
• Trade-off is between reduced product cost and
  increased holding cost, as while

A typical quantity discount schedule
35
Quantity Discount Models
Total cost Setup cost Holding cost Product
cost (We use IP instead of H, as holding cost as
a percent of unit price)
Steps in analyzing a quantity discount

• For each discount, calculate Q
• If Q for a discount doesnt qualify, choose the
  smallest possible order size to get the discount
• Compute the total cost for each Q
• (calculated or adjusted)
• Select the Q that gives the lowest total cost

36
Quantity Discount Example
Calculate Q for every discount
37
Quantity Discount Models
38
Quantity Discount Example
Calculate Q for every discount
39
Quantity Discount Example
Table 12.3
Choose the price and quantity that gives the
lowest total cost Buy 1,000 units at 4.80 per
unit
40
ABC Analysis

• Divides inventory into three classes based on
  annual dollar volume
• Class A - high annual dollar volume
• Class B - medium annual dollar volume
• Class C - low annual dollar volume
• Used to establish policies that focus on the few
  critical parts and not the many trivial ones

41
ABC Analysis

• 80-20 Rule
• 80 of sales will come from 20 of the inventory
  SKUs.
• 20 of sales will come from 80 of the inventory
  SKUs.
• The 80-20 Rule has been found to explain many
  phenomena that interest managers.
• For example, 80 of sales come from 20 of
  customers and vice versa.
• Separates the trivial many from the vital few.

42
ABC Analysis
43
ABC Analysis
44
ABC Analysis
45
ABC Analysis

• Other criteria than annual dollar volume
• Anticipated engineering changes
• Delivery problems
• Quality problems
• High unit cost

• Policies employed may include
• More emphasis on supplier development for A items
• Tighter physical inventory control for A items
• More care in forecasting A items

46
Inventory Visibility

• The ability of the firm to see inventory on a
  real-time basis throughout the supply chain
  system requires
• Tracking and tracing inventory SKUs for all
  inbound and outbound orders.
• Providing summary and detailed reports of
  shipments, orders, products, transportation
  equipment, location, and trade lane activity.
• Notification of failures in inventory flow.

47
Inventory Visibility General Benefits

• Improved customer service
• Decreased cost-of-sales
• Improved vendor relations and cost
• Increased Return on Assets
• Improved cash flow
• Improved response time and service recovery
• Improved performance metrics

48
Evaluating the Effectiveness of Inventory
Management

• Are customers satisfied with the current level of
  customer service?
• How frequently does backordering or expediting
  occur?
• Is the company calculating an Inventory Turnover
  for each product SKU?
• How does inventory level behave as sales rise or
  fall? (ration of inventory to sales)

49
Key Differences among Approaches to Managing
Inventory

• Pull versus Push
• Pull approach is a reactive system, relying on
  customer demand to pull product through a
  logistics system. MacDonalds is an example.
• Push approach is a proactive system, and uses
  inventory replenishment to anticipate future
  demand. Catering businesses are examples of push
  systems.

50
Key Differences among Approaches to Managing
Inventory

• Pull versus Push
• Pull systems respond quickly to sudden or abrupt
  changes in demand, involve one-way
  communications, and apply more to independent
  demand situations.
• Push systems use an orderly and disciplined
  master plan for inventory management, and apply
  more to dependent demand situations.

51
Summary and Evaluation of EOQ Approaches to
Inventory Management

• New concepts
• JIT, MRP, MRPII, DRP, QR, and ECR also take into
  account a knowledge and understanding of
  applicable logistics trade-offs.
• Number of DCs
• The issue of inventory at multiple locations in a
  logistics network raises some interesting
  questions concerning the number of DCs, the SKUs
  at each, and their strategic positioning.

52
Additional Approaches to Inventory Management

• Three approaches to inventory management that
  have special relevance to supply chain
  management
• JIT (Just in Time)
• MRP (Materials Requirements Planning)
• DRP (Distribution Resource Planning)